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Commercial banks do make some money by providing services such as transaction processing and payroll processing to their clients. However, to a large extent commercial banks make money by making loans to corporations.
Interest income is the predominant source of income for banks around the world. Now, this puts commercial banks in direct competition with investment banks. In both cases, banks are trying to raise money for their client. However, clients in different parts of the world use different mechanisms to raise this money. In some countries, banks are the predominant source of funding whereas, in other countries, markets are the predominant source of funding.
In this article, we will understand the difference between the two sources of funding and will also understand why it matters to commercial banks.
A financial system can be defined as either market-based or bank-based depending upon the manner in which funds are raised in the economy. A system that relies heavily on selling securities in the open market is considered to be a market-based system. Here, investors conduct their own due diligence and bear their own risk when they lend money to corporations.
On the other hand, a financial system in which investors invest their money in banks and these banks then invest the money in corporations is called a bank-based financial system. Here, the bank plays the role of a gatekeeper i.e. they inspect the financials of the company on behalf of the investor before making a final investment.
Both these methods of financing exist in almost every economy around the world. However, a system is called a market-based or bank-based system depending upon the predominant system of investing prevailing in that economy. This is generally measured by the percentage of banking services in the overall economy.
For instance, if we compare the United States and Europe, we discover that the United States is a market-based system whereas Europe is a bank-based system. This is because banking services as a percentage of GDP are almost twice as large as in the United States.
It is important to note that economies cannot change from a bank based to market-based economies overnight. Even the most advanced countries of the world like the ones in Western Europe take decades to transition from one system to another. Hence, this can be considered to be a semi-permanent characteristic of the market.
Now, since the distinction between a bank-based financial system and a market-based financial system is clear, the question arises about why we need to understand these distinctions and what impact they have on the commercial banking sector.
If an economy is bank based, then there is larger market size for the commercial banks. Also, since this is semi-permanent in nature, it means that commercial banks can consider this market size to be stable when they make their long-term plans. Hence, it can be said that commercial banks have much more opportunities in Europe as compared to that in the United States.
Commercial banks not only face competition from their peers but also from investment banks. In a bank-based financial system, the degree of this competition is low. This is because investors have a predisposition to prefer banks over commercial markets. Hence, banks can afford to have a higher profit margin in these countries. This is what makes these countries lucrative for commercial banking operations.
On the other hand, in a bank-based financial system, the information available to the average investor is much less than the one available to banks. Hence, banks can price the risks of their loans more effectively. This gives them an edge over the markets and helps them provide more appropriately priced products and services to their customers.
The bottom line is that when a bank decides whether to provide commercial banking services in a country or not, one of the metrics that they consider is whether the financial system is bank-based or market-based. The distinction between the two types of systems is fundamental since it limits the possible opportunities for commercial banks.
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